Unintended Consequences of MiFID II ?

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MiFID II, the new regulations covering financial markets in the European Union from January, may lead to a shift away from lit markets and also lead to a plummet in volumes from outside the trading bloc.

Octavio Marenzi, founder and chief executive of consultancy Opimas warned of the unintended consequences of MiFID II at a City & Financial Global Conference on the new regulations, hosted by law from Norton Rose Fulbright, in London today. He said that under MiFID II systematic internalisers do not have requirements for a minimum tick size and so could post quotes inside the spread on multilateral trading facilities and regulated markets.

Octavio Marenzi, Opimas

“High-frequency traders are are knocking on the door of the buyside and offering to get a price improvement in return for interacting with their flow,” Marenzi added.”There will be increased volumes in SIs to the detriment of lit markets, which is the opposite of the regulatory intent.”

In 2007 MiFID introduced the category of systematic internalisers for trading equities outside a regulated venue. However only nine banks became SIs and very few trades took place on the back of an SI quote as off-venue trading moved to broker crossing networks. MiFID II does not allow brokers to cross internal flows without registering as a systematic internaliser and defines thresholds for becoming an SI based on “frequent and systematic” and “substantial” trading volumes outside regulated venues. As a result, there have been estimates that a large number of SIs will emerge under MiFID II.

MiFID II is also introducing double volume caps on dark pool trading of 4% on any single venue and 8% market-wide in any 12-month rolling period, although large-in-scale block trades are excluded from these limits.

Marenzi continued that the dark pool caps will also boost SI volumes. “High-frequency traders could set up as SIs and some are making an exuberant interpretation of post-trade transparency regulations by not intending to post prices until a minute after a trade,” he said.

In addition, Marenzi said US dark pools, which do not face volume caps, could step in as they could clear trades in in Europe, for example through LCH, the London Stock Exchange Group’s clearing house.

Nick Dutton, head of compliance at Bats Europe, said at the conference: “We are happy to to compete against anyone and it is not the regulator’s job to protect us. We don’t see a dramatic shift due to the differences in tick size.”

Dutton added that if US dark pools are not treated as equivalent by the European Securities and Markets Authority, then EU firms would not be able to meet the obligation to trade on EU authorised venues.

Martin Koder, senior manager, LSEG EU Regulatory Strategy, Capital Markets at London Stock Exchange Group, said at the conference: “We are pro-competition. There will be a different treatment of SIs but we do not foresee an apocalypse.”

Koder continued that the LSE welcomes the increased transparency and competition under MiFID II. “All FTSE 100 stocks will hit volume caps on day one but we have developed solutions for large-in-scale block trading such as Turquoise Plato and the midday auction.”

Last year Plato Partnership, the non-profit group, agreed a cooperation agreement with Turquoise, the multilateral trading facility majority-owned by the London Stock Exchange Group, to bring together the buyside, sellside and a trading venue and increase efficiencies in anonymous European equity block trading. Bats Europe also licensed technology from Bids Trading, the largest block trading ATS by volume in the US, to launch Bats LIS and the exchange has introduced a periodic auction.

Richard Gardiner, head of public and regulatory affairs at the Federation of European Securities Exchanges, said at the conference that members were concerned about how the dark pool volume caps will be implemented. Gardiner was also worried about the ability to trade non-EU stocks in Europe, for example, Apple shares which are listed on Nasdaq in the US but can also be traded on Germany’s Deutsche Börse.

Last year law firm Ashurst highlighted that sending orders to non-MiFID II venues and counterparties in order to achieve best execution in deeper pools of liquidity may be prohibited.

“To put the problem in its starkest terms EU investment firms will not be able to carry out transactions, in dual listed securities, on foreign markets,” said Ashurst. “Instead, they could be forced to undertake this transaction on the EU trading venue, with best execution suffering.”

If non-EU venues are is granted equivalence as a third country venue under MiFID II by Esma then the current arrangements could continue.

“However, this does not deal with the issue that significant amounts of volume are traded away from the lit order book – this kind of liquidity would not be available to EU investment firms,” said Ashurst. “Instead, the EU investment firm would have to execute (for example) on Xetra or a systematic internalizer (i.e. EU investment firm dealing on own account).”

Andrew Douglas, chief executive of DTCC Derivatives Repository Ltd and managing director of DTCC government relations for Europe and Asia, said at the conference that he had just sent two weeks in Asia and met concerns about MiFID II. All counterparties that trade with an EU counterparty, regardless of their location, will need legal entity identifiers but in Asia there is no regulatory requirement for LEIs, unique alpha-numeric codes that identity legal entities globally.

Douglas said: “There is a risk that from January 3 Asian counterparties will not have LEIs and so will choose to trade outside the EU. Only 3% of global LEIs issued are in Asia.”

Mark Kelly, director of professional services at NEX Regulatory Reporting agreed that non-EU participation could plummet. Kelly said that under MiFID II, MTFs need the personal identity information of traders, such as a passport number, at the time of an order – even if an order is not executed, for reporting purposes.

Kelly said at the conference: “Non-EU firms could use a local broker so they do not need to provide personal identifiers but they will still need an LEI.”